Weekly Holla! Prisons Break (Again) [Omotayo Okusanya, George Hoglund, Jonathan Petersen]

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The RMZ was up (+1.5%) last week, outperforming the S&P 500 (+0.5%), as the 10 Year Treasury yield decreased 3 bps to 1.60%. Industrial (+2.7%) Office (+2.6%), and Infrastructure (+2.2%) outperformed. Prisons (-6.8%) underperformed on more negative sector news (see below). Lodging (-2.0%) and Retail - Malls (+1.1%) also underperformed.

STIFEL: KRC ($72.63, Buy) - Gold Rush in San Francisco; Target Price $80/sh; Maintain Buy

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Gold Rush in San Francisco; Target Price $80/sh; Maintain Buy

  • We have chosen to run the numbers by hand and have come up with the following conclusion: selling a 44% interest in two assets for $508mm ($1.155B at 100%), a value over 2.7x the cost to acquire the assets, creates value and increases NAV.
  • Kilroy acquired the two assets, 303 Second and 100 First Street, in 2010 for $354/SF. The just announced joint venture values these two assets at $963/SF and a quoted 'low 4%' cash cap rate.
  • We think the transaction underscores the willingness of offshore global capital to pay very full prices for assets in barrier-to-entry markets and make major investments in Gateway City office REITs. We expect additional similar investments to occur selectively throughout our coverage.

 

  • After adjusting our estimates for this transaction, we are increasing our target price to $80/sh. The new target price equates to 2017E FFO/FAD/sh multiples of 22.5x/35.4x, a 4.8% implied NOI cap rate and a TEV of $637/SF, versus our estimate of adjusted replacement cost of $538/SF.

 

  • We estimate that Kilroy Realty currently trades at very reasonable real estate valuation metrics: 1) 5.3%/4.5%/3.8% for Implied NOI, Cash Flow, and CF less G&A Cap Rates. TEV/SF of $584/SF is also reasonable relative to our estimates of $620/$538/SF for gross/adjusted replacement cost. Finally, KRC trades at a 16%/6% discount to our 4.5%-5.0% NAV range.

 

  • This accentuates the pivotal question with REIT valuations -- does a discount to NAV and other attractive real estate valuations offset historically high FFO/FAD multiples?

 

 

  • While clearly Net Asset Value accretive, the transaction will result in cash staying on the balance sheet until spent on development, and near term earnings dilution.

 

  • We are adjusting 2016 FFO/FAD/sh estimates to $3.38/$2.19 from $3.40/$2.21 and our 2017 FFO/FAD/sh to $3.55/$2.26 from $3.57/$2.27. We estimate the normalized 2015-2017 FFO/FAD growth to be 5.0%/7.7%.

Target Price Methodology/Risks

  • Our target price of $80/sh, equates to 22.5x/35.4x on our updated 2017 FFO/FAD/sh estimates of $3.55/$2.26 and an implied NOI cap rate of 4.8%.
  • Risks to achieving our target price include development and lease-up risk, tech bubble fears, interest rate and general economic risk.

Japan REIT sector - REITs up despite ex-dividend date for 11 REITs

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Stocks should benefit from BOJ buying, REITs seem also to be in favor

TOPIX rose 2% on 29 August from the previous trading day. The main factor was likely the yen's retreat following the Fed chairwoman's lecture and comments by BOJ Governor Haruhiko Kuroda at the symposium at Jackson Hole, Wyoming, on 26 August. Amid these conditions the TSE REIT index rose 0.5% on 29 August despite it being the ex-dividend date for REITs with August-ending fiscal periods (ie, 11 of the 54 REITs). After nearly doubling its annual ETF buying target to roughly ¥6trn (from ¥3.3trn) at the 29 July Monetary Policy Meeting, the BOJ bought ¥71.9bn in ETFs on both 25 and 26 August, roughly double the daily amount of BOJ ETF buying up to 3 August. Even so, TOPIX continued to fall d-d on 25 and 26 August. On the other hand, the BOJ did not buy REITs on 25 or 26 August, but the TSE REIT index rose each day nonetheless. Judging from these market conditions, our view is that market participants feel safer in REITs than stocks.

NOMURA - Sanki Engineering (1961 JP) (Neutral) Effect of suspension not clear yet

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Real estate business also warrants attention

In Apr-Jun 2016, operating losses narrowed to ¥0.3bn, from ¥0.6bn the year earlier, although Apr-Jun results make only a small contribution to full-year results owing to seasonal factors. Losses narrowed owing to an increase in revenues in the machinery systems business, offsetting an increase in provisions against construction losses in the facilities construction business, which includes the HVAC systems for buildings business. As announced by the company on 23 June, the government suspended the company from participating in bids and contracts for 30 days, from 8 July to 6 August, in connection with antitrust law violations. We will be paying close attention to the effect of the suspension on earnings in Jul-Sep and beyond. Peers that were similarly suspended in 15/3 saw earnings adversely affected in cases where the companies also refrained from actively taking on work in the private sector. We make no change to our operating profit forecasts, but we lower our target price as we cut our target P/E to 11-12x, from 16-17x previously, to reflect trends in the benchmark P/E and other factors.